Differing views on macroeconomic stabilisation

The economy has been experiencing macroeconomic stabilisation measures since 2023. These stabilisation measures have impacted the real economy to a great extent. They are being implemented under the programmes of the International Monetary Fund (IMF). Generally, there are two views on these measures.

Since developing economies are constrained by foreign exchange, they have to adopt these measures when they face balance-of-payments (BOP) crises. According to the mainstream or traditional paradigm, the first measure of stabilisation is the devaluation of the rupee vs the US dollar. This devaluation is carried out to correct the exchange rate as it is presumed overvalued.

The devaluation is also accompanied by monetary restriction. Monetary brakes are applied through a high policy rate set by the State Bank of Pakistan (SBP). In the event of high devaluation, the SBP jacks up the policy rate in quick successions. The objective of raising the policy rate is to decelerate the pace of inflation in the economy.

Another essential measure is the reduction in fiscal deficit. It is assumed that there is an excess demand in the economy. An increase in fiscal deficit will increase the rate of inflation. Hence, the objective of the reduction in fiscal deficit is to reduce the rate of inflation.

Stabilisation measures also include a unified exchange rate. In addition, exchange controls are not allowed under the Extended Fund Facility (EFF). The objective of exchange freedom is to restore the confidence of international institutional investors. As the confidence of investors is restored, foreign loans start to flow in. In addition, foreign portfolio investment and foreign direct investment also start to pour in. Hence, the capital inflow.

Now, we look at the stabilisation measures from an alternative perspective, which is known as another view. According to this paradigm, the devaluation of the rupee will incentivise primary exports as developing economies are mainly the primary goods exporters. Most of their exports are agriculture based while the share of manufacturing exports is minimal.

In addition, the devaluation has a deleterious impact on import substitution industries whereas these industries play a vital role in saving the precious foreign exchange reserves.

The application of monetary restrictions slows down the growth of real output or GDP. Even the GDP growth rate turned negative when the SBP raised the policy rate in quick successions. Hence, monetary restrictions bring recession to the economy.

As the real economy slows down, the number of transactions decreases in the economy. The reduction in transactions brings down the collection of revenue. Owing to repeated stabilisation measures, the tax-to-GDP ratio could not be improved. Hence, the average tax-to-GDP ratio has been hovering around 9% over the last 25 years.

Apart from recession and the low tax/GDP ratio, the economy experiences a high inflation rate. This phenomenon is called recessive inflation or slumpflation. Hence, a combination of low or stagnant GDP growth and high inflation is the outcome of conventional stabilisation measures.

Under these set of conditions, trade bodies, industrial associations and chambers of commerce start to raise hue and cry since the element of demand is missing from these stabilisation measures. Industrialists could not utilise their capacity up to the optimum level. In addition, opposition parties and members of parliament also criticise the sordid state of economy.

The government knuckles under this pressure. It starts to loosen its purse strings to reactivate the economy. This reactivation is usually carried out as the government is out of the IMF programme. A typical election cycle consists of five years. The first three years are given to stabilisation measures while the last two are the years of reactivation.

In brief, the above views reflect two different paradigms: mainstream and alternative. The alternative paradigm requires technically sound and coherent proposals, which may lead to a home-grown solution. Otherwise, the economy will keep experiencing stabilisation measures.

The writer is an independent economist and authored a book: Pakistan's Structural Economic Problems in the era of Financial Globalization